When to Exercise Your Employee Stock Options

Compensation plans are continually evolving as organizations compete to attract talented individuals. Indeed, employee stock options are increasingly playing a larger role in executive compensation packages. For example, stock options comprised 11.1% of CEO pay and 9.3% of non-CEO executive pay in 2019. In 2020, these percentages rose to 19.1% and 15.8%, respectively, according to research from Harvard Law School.

Stock options can be a valuable component of your total compensation. At the same time, they can be complex and, in some cases, result in a significant tax liability. Therefore, it’s important to understand the details of your stock option agreement—and when it makes sense to exercise your options—so you can maximize your potential earnings and minimize your overall tax bill.

What Is an Employee Stock Option?

In general, a stock option is a contract that gives an employee the right to buy a set number of shares of company stock at a preset price (also known as the grant price) before an expiration date. The number of options varies by employee; this number is usually tied to the employee’s seniority level, experience, and/or special skills.

If you receive employee stock options, your options begin to vest on the grant date. Typically, options vest gradually over a several-year vesting period. Except in certain cases, you can’t exercise your stock options until they fully vest.

Both privately held and publicly traded companies can offer employees stock options as part of their overall compensation package. For example, many professionals who join startups receive stock options in exchange for taking an initial salary cut. However, publicly traded companies may also use stock options to tie executive compensation to stock performance.

Types of Employee Stock Options

There are two types of stock options employers may grant: incentive stock options (ISOs) or nonqualified stock options (NSOs). The main difference between the two is how they’re treated for tax purposes.

If you receive ISOs, it’s important to understand the rules associated with them prior to exercising, as they often come with a strict set of guidelines. On the plus side, ISOs also receive favorable tax treatment.

For example, exercising your ISOs isn’t a taxable event. In addition, if you exercise and hold the shares for more than two years from the grant date and one year from the exercise date, the long-term capital gains tax rate applies if you sell the shares for a profit. In 2022, the capital gains rate maxes out at 20%.

On the other hand, NSO profits are taxed at your ordinary income tax rate when you exercise your options. If you then hold onto your shares and sell them after one year, the long-term capital gains tax rate applies. However, if you sell your shares within the first year, you’ll pay the ordinary income tax rate on any profits since it’s considered a short-term capital gain.

Exercising Your Stock Options

The primary reason you may choose to exercise your employee stock options is because they’re “in the money.” When options are in the money, the current stock price exceeds your grant price. In other words, you can purchase shares of your company stock at the grant price and make an immediate profit.

In a privately held company, you might anticipate an initial public offering (IPO) or merger/acquisition to put your stock options in the money. With a publicly traded company, your stock options may be valuable simply because you expect the company to perform well in the future.

In most cases, you can only exercise in-the-money options after they vest and before they expire. Some companies allow early exercise, which gives you the option to exercise your options before they vest. Your tax situation may also influence your decision of when and how you exercise your employee stock options.

Scenario #1: Your Options Are About to Expire

If you’re confident in your company’s long-term viability, it almost always makes sense to exercise your stock options before they expire. Otherwise, your options expire worthless, and you lose your opportunity to potentially profit from them.

If you leave the company before exercising your options, you’ll want to find out how long you have before they expire. Typically, ISOs expire 90 days after your termination date, while NSOs may take longer to expire.

Many employers will automatically exercise your options for you at the expiration date, provided they are in the money. Be sure to check your agreement to see if your employer provides this service. Otherwise, you’ll want to keep track of your expiration dates to make sure you don’t miss your window of opportunity.

Scenario #2: You Decide to Exercise Your Options Early

If your company allows early exercise, it may be advantageous to exercise your options before they vest. First, your tax liability at the time of exercise may be negligible since the IRS doesn’t require individuals to recognize unvested assets as income. In addition, you can start the clock early on your holding period. That way, the long-term capital gains rate is more likely to apply when you eventually sell your shares.

With early exercise, a good rule of thumb is typically to only exercise the number of options you expect to vest during your time at the company. If you leave before the options vest, the opportunity cost of tying up your cash in company stock may exceed the potential benefits of exercising early.

In addition, you may want to consider filing an 83(b) election with the IRS within 30 days of your exercise date to establish the purchase price. Otherwise, the IRS may use the stock’s fair market value on the day your shares vest to determine your tax liability.

Other reasons you may decide to exercise your employee stock options early include:

• You believe the company’s future performance may suffer. Therefore, you want to exercise your options and sell your shares before the stock price turns negative.
• You’ve accumulated a concentrated position in your company’s stock and want to sell some shares to diversify your assets.

Scenario #3: You Want to Reduce Your Tax Liability

Lastly, you may decide to exercise your options as they vest to minimize your overall tax liability. Indeed, exercising your options all at the same time may push you into a higher income tax bracket for that tax year, depending on your profits. On the other hand, exercising your options each year as they vest can help you minimize potential tax consequences.

Other Factors to Consider When Exercising Stock Options

Like most financial decisions, the decision to exercise your employee stock options shouldn’t be made in a vacuum. There are other factors you’ll want to consider before proceeding.

For example, you’ll want to make sure you have enough cash available at the time of exercise. Naturally, you’ll need enough cash on hand to purchase shares of your company stock.

However, you’ll also want to make sure you have enough cash leftover to cover your near-term financial needs. Selling your shares prematurely to free up cash can have serious tax consequences.

In addition, be sure to evaluate your competing financial priorities. For example, if your children are approaching college age or you recently bought a second home, you may not want to take on undue risk that could potentially preclude you from meeting your obligations.

Finally, consider what exercising your options means within the context of your overall investment plan. Concentrating too much of your wealth in company stock—or equity markets in general—may increase your risk of permanent capital loss in the event of a downturn.

Consider Consulting a Trusted Advisor When Evaluating Your Options

Ultimately, stock options are meant to be a valuable component of your overall compensation plan. Nevertheless, employee stock options can be complex and often come with a strict set of rules. To avoid costly missteps, consider consulting a trusted advisor, who can help you determine when and how to successfully exercise your options.

SageMint Wealth has extensive experience working with executives and high-earning professionals. Our goal is to help you maximize your wealth while avoiding unnecessary tax consequences. If we can help you evaluate and develop a plan for your executive compensation package, please get in touch. We’d love to hear from you.

Content in this material is for general information only and not intended to provide specific advice

or recommendations for any individual. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Investing includes risks, including fluctuating prices and loss of principal.

The financial advisors of SageMint Wealth are registered with, and securities and advisory services are offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC.